A flat rate charges interest on the full original loan amount for the whole tenure, while a reducing rate charges interest only on the principal still outstanding each month. The same quoted percentage therefore costs more under the flat method: 10% flat on a 3-year loan works out to about 17.92% a year on a reducing balance.
Flat vs Reducing Interest Rate at a Glance
| Comparison Factor | Flat Interest Rate | Reducing Balance Interest Rate |
|---|---|---|
| Basis of interest | Original principal, for the full tenure | Outstanding principal, recalculated each month |
| Total interest formula | Principal × annual rate × years | (EMI × number of months) − principal |
| EMI formula | (Principal + total interest) ÷ months | P × i × (1 + i)^N ÷ ((1 + i)^N − 1) |
| Interest part of each EMI | Same every month | Falls every month |
| Principal part of each EMI | Same every month | Rises every month |
| Quoted rate vs effective annual rate | Effective rate is higher than quoted | Quoted rate is the rate charged on the balance |
| Reducing-balance equivalent of 10% over 3 years | About 17.92% | 10.00% |
In the EMI formula, P is the principal, i is the monthly rate (annual rate ÷ 12 ÷ 100) and N is the number of monthly instalments. The equivalent rate in the last row comes from the worked example below and excludes fees and charges.
How Each Method Calculates Interest
Under the flat method, the lender multiplies the original principal by the annual rate and by the tenure in years. That total interest is added to the principal and the sum is divided by the number of months. Every instalment contains the same amount of interest, even though the borrower owes less after each payment.
Under the reducing balance method, interest for a month is the outstanding principal multiplied by the monthly rate. The EMI stays the same, but the split inside it changes: the interest part shrinks as the balance falls, and the principal part grows by the same amount.
On a ₹10,00,000 loan at 10% a year, the first month's interest is ₹8,333 under both methods, because the full amount is still outstanding. From the second month the two diverge. The flat loan keeps charging ₹8,333 every month, while the reducing loan charges ₹8,134 in month 2 and ₹267 in month 36.
Worked Example: Same Loan, Both Methods
The example uses an assumed rate of 10% a year on a ₹10,00,000 loan repaid over 36 months, with no fees. The rate is illustrative and is not any lender's offer. Rupee figures are rounded to the nearest rupee, and totals are computed from the unrounded EMI.
| Loan Parameter | Flat Rate Method (10% p.a.) | Reducing Balance Method (10% p.a.) | Difference |
|---|---|---|---|
| Principal | ₹10,00,000 | ₹10,00,000 | None |
| Tenure | 36 months | 36 months | None |
| Quoted rate | 10.00% p.a. | 10.00% p.a. | None |
| Monthly EMI | ₹36,111 | ₹32,267 | ₹3,844 |
| Total interest | ₹3,00,000 | ₹1,61,619 | ₹1,38,381 |
| Total repaid | ₹13,00,000 | ₹11,61,619 | ₹1,38,381 (11.9% more) |
| Effective reducing-balance rate | 17.92% p.a. | 10.00% p.a. | 7.92 percentage points |
Flat interest is ₹10,00,000 × 10% × 3 = ₹3,00,000, so the flat EMI is ₹13,00,000 ÷ 36 = ₹36,111.11. The reducing balance EMI from the formula is ₹32,267.19, and 36 such payments add up to ₹11,61,619. The flat loan costs about 1.86 times as much interest as the reducing loan at the same quoted rate.
The month-by-month split shows where the gap comes from. Interest and principal in a row may differ from the EMI by ₹1 because each figure is rounded separately.
| Month | Flat: interest in EMI | Flat: principal in EMI | Reducing: interest in EMI | Reducing: principal in EMI | Reducing: balance after EMI |
|---|---|---|---|---|---|
| 1 | ₹8,333 | ₹27,778 | ₹8,333 | ₹23,934 | ₹9,76,066 |
| 12 | ₹8,333 | ₹27,778 | ₹6,046 | ₹26,222 | ₹6,99,258 |
| 24 | ₹8,333 | ₹27,778 | ₹3,300 | ₹28,967 | ₹3,67,023 |
| 36 | ₹8,333 | ₹27,778 | ₹267 | ₹32,001 | ₹0 |
How to Convert a Flat Rate to a Reducing Rate
There is no exact one-line formula for the conversion. The equivalent reducing rate is the rate at which the reducing balance EMI formula produces the same EMI as the flat loan. It is found by trial and error or with a spreadsheet function such as RATE or IRR, and it depends on the tenure as well as the flat rate.
The steps are: work out the flat EMI, then search for the monthly rate i that gives the same EMI in the reducing balance formula, then multiply i by 12. For the worked example, the flat EMI of ₹36,111 on ₹10,00,000 over 36 months corresponds to a monthly rate of about 1.493%, or 17.92% a year.
| Flat Interest Rate (% p.a.) | Loan Tenure (Years) | Equivalent Reducing Rate (% p.a.) | Ratio to Flat Rate |
|---|---|---|---|
| 5.00% | 3 | 9.31% | 1.86 |
| 6.00% | 3 | 11.08% | 1.85 |
| 7.00% | 5 | 12.50% | 1.79 |
| 8.00% | 1 | 14.45% | 1.81 |
| 8.00% | 3 | 14.55% | 1.82 |
| 8.00% | 5 | 14.13% | 1.77 |
| 8.00% | 7 | 13.69% | 1.71 |
| 10.00% | 3 | 17.92% | 1.79 |
| 10.00% | 5 | 17.27% | 1.73 |
| 12.00% | 5 | 20.31% | 1.69 |
Every row assumes monthly instalments and no fees, with the equivalent rate rounded to two decimals. The ratio in these rows runs from 1.69 to 1.86, so the common shortcut of multiplying a flat rate by about 1.8 is only an approximation. It overstates the result for longer tenures and higher rates: 8% flat over 10 years is equivalent to 13.12% (a ratio of 1.64), and over 20 years to 11.74% (a ratio of 1.47).
Which Loans Use Which Method
The Reserve Bank of India (RBI) does not leave the choice entirely to lenders. Its Master Direction on Interest Rate on Advances, 2016, which applies to scheduled commercial banks, small finance banks and local area banks, says interest shall be charged on all advances at monthly rests, with separate treatment for agricultural advances. The direction itself does not use the terms flat rate or reducing balance.
For microfinance loans, the RBI's 2022 directions require a standard pricing factsheet. Its illustrative format shows the effective annualised interest rate computed on the net disbursed amount using the IRR approach and the reducing balance method.
On 12 August 2026 the RBI published the draft Reserve Bank of India (Interest Rates on Loans and Advances) Directions, 2026 for public comment. The draft covers commercial banks, regional rural banks, co-operative banks, all-India financial institutions and non-banking financial companies including housing finance companies. It states that interest shall be computed on a daily reducing balance basis and gives 1 April 2027 as the date the directions would come into effect. It is a draft, not a final rule.
| RBI Document | Lenders Covered | Interest or Disclosure Basis | Date or Status |
|---|---|---|---|
| Master Direction on Interest Rate on Advances, 2016 | Scheduled commercial banks, small finance banks, local area banks | Interest charged at monthly rests | Issued 2016 |
| Regulatory Framework for Microfinance Loans Directions, 2022 | Lenders giving microfinance loans | Factsheet rate on IRR and reducing balance basis | Issued 2022 |
| Key Facts Statement circular, 15 April 2024 | Banks and NBFCs, for retail and MSME term loans | APR and amortisation schedule disclosed | Loans sanctioned from 1 October 2024 |
| Draft Interest Rates on Loans and Advances Directions, 2026 | Banks, AIFIs, NBFCs including HFCs | Daily reducing balance | Draft; proposed from 1 April 2027 |
Is Flat or Reducing Interest Rate Better?
At the same quoted percentage, the reducing balance loan always costs less, because the flat loan keeps charging interest on principal that has already been repaid. In the worked example the difference is ₹1,38,381 over three years.
The comparison changes when the two quoted percentages differ. A flat rate is cheaper than a reducing rate only when its reducing-balance equivalent is the lower number. On a 3-year loan, 5% flat (equivalent to 9.31%) costs less than 10% reducing, while 6% flat (equivalent to 11.08%) costs more.
The RBI's Key Facts Statement (KFS) circular of 15 April 2024 gives borrowers a common yardstick. For retail and MSME term loans sanctioned on or after 1 October 2024, the lender has to provide a KFS that includes a computation sheet for the Annual Percentage Rate (APR) and the amortisation schedule for the full tenure. The circular defines APR as the annual cost of credit to the borrower, including the interest rate and all other charges. Fees not mentioned in the KFS cannot be charged during the loan without the borrower's explicit consent. Credit card receivables are exempt.
What is the difference between a flat interest rate and a reducing interest rate
The difference is the amount on which interest is charged. A flat rate applies to the amount originally borrowed for the entire tenure. A reducing rate applies to the principal that remains unpaid, which falls with every instalment.
| Comparison Parameter | Flat Interest Rate | Reducing Balance Interest Rate |
|---|---|---|
| Principal used for interest | Original loan amount | Outstanding balance |
| Effect of each repayment on later interest | None | Lowers it |
| EMI on ₹5,00,000 at 12% p.a. for 5 years | ₹13,333 | ₹11,122 |
| Total interest on that loan | ₹3,00,000 | ₹1,67,333 |
| Effective reducing-balance rate on that loan | 20.31% p.a. | 12.00% p.a. |
The 12% rate in the table is assumed for illustration. Amounts are rounded to the nearest rupee and exclude fees.
Is reducing interest rates good or bad
For a borrower comparing two loans at the same quoted rate, the reducing balance method is the cheaper one. Interest is charged only on money still owed, so the cost falls as the loan is repaid.
The effect grows with the size and length of the loan. On a ₹50,00,000 loan over 20 years at an assumed 8% a year, the reducing balance EMI is ₹41,822 and total interest is ₹50,37,281. A flat 8% on the same loan would mean total interest of ₹80,00,000 and an EMI of ₹54,167, which is ₹29,62,719 more interest and equivalent to a reducing rate of 11.74%.
A part-prepayment on a reducing balance loan cuts the balance on which later interest is charged. In the ₹10,00,000 worked example, a ₹1,00,000 prepayment made with the 12th EMI, with the EMI left unchanged, closes the loan in 33 months instead of 36 and lowers total interest from ₹1,61,619 to ₹1,40,989, a reduction of ₹20,630. This calculation ignores any prepayment charge.
Key Takeaways
- A flat rate charges interest on the original principal for the full tenure; a reducing rate charges it on the outstanding balance.
- On ₹10,00,000 over 36 months at 10%, total interest is ₹3,00,000 under the flat method and ₹1,61,619 under the reducing balance method.
- A 10% flat rate over 3 years is equivalent to about 17.92% on a reducing balance; 8% flat over 5 years is equivalent to about 14.13%.
- The ratio between the two rates is not fixed. It ranged from 1.69 to 1.86 in the cases computed here and falls as the tenure lengthens.
- Under the RBI's KFS circular, retail and MSME term loans sanctioned from 1 October 2024 carry a disclosed APR and an amortisation schedule.
Frequently Asked Questions (FAQs)
What is the key difference between a flat interest rate and a reducing balance rate?
A flat rate calculates interest on the entire original principal for the full tenure. A reducing balance rate calculates interest only on the principal outstanding after each monthly repayment. At the same quoted percentage, the flat method produces higher total interest.
How do I convert a flat interest rate to an equivalent reducing balance rate?
Calculate the flat EMI, then find the rate at which the reducing balance EMI formula gives the same EMI, using a spreadsheet RATE or IRR function. An 8% flat rate on a 5-year loan with monthly instalments is equivalent to about 14.13% on a reducing balance. Multiplying the flat rate by about 1.8 gives a rough estimate only.
Which interest rate method do Indian home loan lenders use?
The RBI's Master Direction on Interest Rate on Advances, 2016 requires banks to charge interest on all advances at monthly rests. A draft RBI direction published on 12 August 2026 proposes interest on a daily reducing balance basis for banks and for NBFCs including housing finance companies, with effect from 1 April 2027.
Why does a flat interest rate result in higher total interest cost?
A flat rate charges interest on the initial loan amount until the last instalment, even though each EMI repays part of the principal. On a ₹5,00,000 loan at 10% flat for 5 years, total interest is ₹2,50,000, compared with ₹1,37,411 at 10% on a reducing balance.
How is EMI calculated under a flat interest rate structure?
Flat rate EMI = (principal + total interest) ÷ number of months. Total interest is the principal multiplied by the annual flat rate and by the tenure in years. For ₹10,00,000 at 10% for 3 years, that is ₹13,00,000 ÷ 36 = ₹36,111.
Can I prepay a loan taken on a flat interest rate?
Prepayment terms and charges are set by the loan agreement and vary by lender and loan type. On a reducing balance loan, a prepayment lowers the outstanding principal, and interest from the next month is charged on the smaller balance.
Which type of interest rate is better for long-term loans like home loans?
At the same quoted rate, the reducing balance method costs less, and the gap widens with tenure. On ₹50,00,000 over 20 years at an assumed 8%, total interest is ₹50,37,281 on a reducing balance against ₹80,00,000 at a flat rate.
